More on Profit Margins

An update to last week’s look at how QE2 may impact corporate profit margins.

First, a chart of S&P 500 revenues and profits. This view complements the profit margin chart from last week. Profit has recovered to within 10% of the all-time peak but revenue has only recovered to 15% of peak. Demand remains relatively weak with some of the rebound in profit due to the significant cost cutting done by major corporations.

There was much in the news this week regarding margins; key exerpts below.

From the Wall Street Journal article “Growth in Profit, But Concerns Over Sales” (emphasis mine):

Corporate America is on track to post its healthiest profit margins in more than three years in the current third-quarter earnings season. But some companies are warning that skittish consumers and higher raw-materials prices promise a tougher road next year, damping hopes for resurgence in hiring.

Against that backdrop, S&P says corporate operating margins will narrow to 8.85% in the fourth quarter from 8.94% in the third. Margins at a number of big companies are already under pressure from more costly raw materials or the need to spend more on promotions or discounts to attract consumers.

3M’s raw-material costs were up 2.5% from a year earlier, while its high-margin business in medical supplies was hurt by a drop in hospital admissions, as consumers delayed elective treatments.

More pressure may lie ahead. TV makers Sharp Corp. and LG Electronics Inc. warned last week that soft North American demand and a surge in production had created a glut of LCD TVs and screens. The impact already has filtered down to 3M, which makes films that enhance the picture quality of LCD screens, and has seen orders fall sharply in recent weeks as TV production has slowed. The slowdown is likely to reduce fourth-quarter profit by about $70 million, 3M said.

Input price pressure and worries about future demand seem to be holding corporations back from major expansion and hiring plans. These concerns can also be seen in the NFIB Small Business Economic Trends Report. As of September only 6% of respondents thought it a good time to expand and only 19% were planning a capital expenditure in the next three to six months, both well below average. In addition, 3% more respondents thought sales would be lower than those who thought they would be higher over the next three months. A net of 3% also plan on lower staffing and inventory levels.

Also, from Goldman Sachs stock market strategist David Kostin we get the following (emphasis mine):

Capacity utilization hovers at 74%, up from the March 2009 low of 68% but below the 81% long-term average, so firms are not compelled to fast-track new projects despite the availability of cheap financing. The U.S. has a demand, not a supply, problem.

If the Fed successfully spurs higher inflation than we currently assume (1.1% in 2011), it will have a negative impact on profit margins because rising input costs will not be fully-passed through to the consumer. Passing inflation along to the end customer will be particularly difficult in an environment with nearly 10% unemployment.

Finally, it appears the consensus among analysis is a continuation of this earnings recovery. From Zacks, via Pragcap:

Regardless of some of the technical timing issues, it means that earnings will have fully recovered by mid 2011, and that full-year 2011 earnings will be 8.5% above full-year 2007 earnings (before the Great Recession started). That is years before we are likely to see a full recovery in the job market.

Collectively the 500 firms in the S&P 500 earned $546.5 billion in “2009,” and that is going to grow to $759.8 billion this year and $878.4 billion in 2011. Translated into “EPS” for the index, earnings are expected to rise from $57.64 in 2009 to $79.80 in 2010 and $92.78 in 2011.

With the consensus forecasting 15% earnings growth in 2011 it will be worth keeping an eye on the margin compression story. To me, it appears these sanguine earnings forecasts are already priced into the market so any downward pressure on revenue or margins from here could cause investors to reconsider if we are really “off to the races.”